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Netflix, Inc. (NFLX)

Q2 2007 Earnings Call

July 23, 2007 5:00 pm ET

Executives

Deborah Crawford - Director, Investor Relations

Reed Hastings - Chairman of the Board, President, Chief Executive Officer

Barry McCarthy - Chief Financial Officer, Secretary

Analysts

Barton Crockett - JP Morgan

Douglas Anmuth - Lehman Brothers

Youssef Squali - Jeffries & Company

Mike Olsen - Piper Jaffray

Tony Wible - Citigroup

Heath Terry - Credit Suisse

Gordon Hodge - Thomas Weisel Partners

Maurice McKenzie - Signal Hill

Jim Friedland - Cowen and Company

Daniel Ernst - Hudson Square Research

Brian Pitz - Bank of America

Presentation

Operator

Good day, everyone and welcome to the Netflix second quarter 2007 earnings conference call. Today’s call is being recorded and at this time for opening remarks and introductions, I would like to turn the program over to Ms. Deborah Crawford, Director of Investor Relations. Please go ahead, Madam.

Deborah Crawford

Thank you and good afternoon. Welcome to Netflix's second quarter 2007 earnings call. Before turning the call over to Reed Hastings, the company’s co-founder and CEO, I’ll dispense with the customary cautionary language and comment about the webcast for this earnings call.

We released earnings for the second quarter at approximately 1:05 p.m. Pacific Time. The earnings release, which includes a reconciliation of all non-GAAP financial measures to GAAP and this conference call, are available at the company’s investor relations website at www.netflix.com. A rebroadcast of this call will be available at the Netflix website after 3:30 p.m. Pacific Time today. We will make forward-looking statements during this call regarding the company’s future performance. Actual results may differ materially from these statements due to risks and uncertainties related to the business. A detailed discussion of such risks and uncertainties is contained in our filings with the Securities and Exchange Commission, including our annual report on Form 10-K filed with the commission on February 28, 2007.

Now I would like to turn the call over to Reed.

Reed Hastings

Thank you, Deborah and welcome to everyone. In the second quarter, Netflix exceeded our profit forecast and delivered one of our most profitable quarters ever. The seasonality in our business means that the second quarter is typically our most profitable and slowest-growing quarter of the year. In the past, slow growth meant a 5% to 10% sequential increase in subscribers. This quarter, due to increased competition, it meant a 1% decline in subscribers. We expect to return to positive sequential growth in the second-half, even assuming no relief from the competitive environment due to higher seasonal growth in the second-half of the year compared to the second quarter.

Partially due to the battle with our competition, the online rental segment as a whole is growing quite remarkably. In the year between mid-2005 and mid-2006, online rental expanded by a healthy 2.5 million net additions. But in the most recent 12 months, from mid-’06 to mid-’07, online additions accelerated to approximately 3.7 million subscribers.

As Internet commerce continues to mainstream, and as video stores close, the prospects for online rental to add over 4 million net new subscribers over the next year are strong. If online rental stays on that 4 million per year track for three years, that would be more than 20 million online subscribers by mid 2010. If online rental achieves these subscriber levels, then the mass closures of the largely fixed cost video stores will help make online rental even more pervasive. Within just a few years, much of the DVD rental market will likely be online rental.

Despite alternatives to DVD rental, such as video-on-demand and DVD sales, domestic DVD rental from Blockbuster, Movie Gallery and Netflix combined grew from Q106 to Q107, the last published quarter.

In other words, online rental growth more than made up for shrinking store rental revenue. Consumers are not shifting away from DVD rental but they are shifting from store-based DVD rental to online DVD rental.

Consumers are choosing online DVD rental in ever greater numbers due to its superior value, convenience and selection. And the online, one distribution center per region model is significantly more efficient than the one video store per neighborhood model.

This year, Blockbuster realized the criticality of online rental and changed its strategy to dramatically increase investment in online rental by giving away one free store rental for every online rental. By literally giving away the store, they have gained online subscribers at the cost of big financial losses.

Earlier this year, we thought Blockbuster might sustain these steep losses for only a quarter or two, as they did in 2005, so we maintained our profit goals and trimmed our subscriber expectations for the year.

At this point, however, we believe it is prudent for us to assume that Blockbuster stays in the online-growth-over-profits mode as long as they can and therefore, we are adapting our competitive posture by shifting some profits to defend our share. If this assumption turns out to be too conservative, that should be upside for us.

As we look at how to grow our business most efficiently, we make trade-offs between service levels, marketing levels and price levels. For example, we are opening 10 or so new distribution centers this year because we find improving service levels with faster delivery is a relatively efficient means of subscriber growth and retention.

Similarly, we are frequently testing lower price points to see if there is enough elasticity to pay for the price cuts. Last month in June, we became convinced that we could cut the price of our two-out unlimited program by a dollar, and it would substantially pay itself back through increased retention and increased organic growth, allowing us to spend less in marketing. We are very pleased with the result of that two-out price cut and we are now extending that reduction to our one-out and three-out customers.

At lower prices, we will spend less acquiring subscribers than we otherwise would have because of the increased attractiveness of our lower-priced programs. In other words, marketing reductions largely fund these price cuts.

Our strategy evolution is shifting some profits into growth investments for as long as our competitor runs their online service at a considerable loss. The tactics of our increased growth investments are higher service levels, lower pricing and slightly less marketing because we believe that is the most efficient combination for Netflix at this point.

Despite the shift of some profits into growth, our full-year subscriber guidance is down slightly but not by as much as it otherwise would have been. We have shifted some profit into growth but are attempting to avoid the trap of overreacting. At some point, our competitor will likely desire at least a modest profit on their online service and we expect Netflix to enjoy greater growth and profitability at that time. The market is large enough that there is room for two large, growing, and profitable online businesses.

The reason the current competition is so intense is the opportunity is quite large, as consumers switch from store rental to online rental. Over the long-term, we think our advantages as an innovative Internet company filled with great talent and fueled by outstanding customer satisfaction are enormous. Couple that with the strength of our balance sheet and we believe Netflix is well-positioned to compete effectively and to emerge from the current battle strong, growing and profitable.

Part of this optimism stems from the progress we’re making in online video, which will grow slowly but steadily over the next five to 10 years. Usage tracking by compete.com already shows us as the leading online movie service by a wide margin and our ability to combine online DVD rental and online video into one service gives us a significant competitive advantage.

We are generating more online video viewing every month. The next big step -- delivering Netflix online video to the television -- we expect to come together next year with a number of partners and we’ll have more to say about that next year. One subscription service with two delivery methods is we believe the path to long-term leadership and profits.

At this point, I’ll turn the call over to Barry to give you some more color on our results.

Barry McCarthy

Thank you, Reed and good afternoon, everyone. My prepared remarks will comment on our financial performance for Q2 and our earnings guidance for the remainder of the year. I’ll also share some preliminary thoughts about guidance for 2008, after which I’ll conclude my remarks with a status update on the $100 million stock buy-back program we announced last quarter.

As Reed mentioned, last quarter’s results were mixed. Subscribers were in the low-end of our guidance range and ending subs actually declined for the first time in our history, which was disappointing.

The good news is that slower subscriber growth was accompanied by lower marketing spending, which resulted in near record high net income, significantly above the high-end of our guidance for the quarter.

Revenue for Q2 was in the low-end of the range of our guidance. This resulted from the sequential decline in ending subscribers. ASP continued to decline as we expected, reflecting the popularity of our lower-priced plans. As in prior quarters, the three-out $17.99 a month program was our most popular offering.

We expect ASP to continue to decline for the foreseeable future, until the mix of new subscribers and existing subscribers reaches equilibrium. I’ll explain why this shift is driving expansion of our gross margin in a moment.

As we forecast on last quarter’s earnings call, our gross margin declined sequentially in Q2. The primary reasons for that decline were: one, the 2% increase in the first-class mail rate we absorbed in May; and two, increasing costs related to our Watch Now online video feature, which we rolled out to our entire subscriber base during the quarter.

With the growing popularity of our online video feature, we expect these costs to increase over the next two quarters and reduce gross margins further, as Netflix subscribers enjoy the immediacy of Internet-delivered video.

These online video costs are another example of the investment spending we talked about to drive increased value for Netflix subscribers. But our gross margin for the quarter was in fact better than we expected because fulfillment and online video costs were less than we expected, and that brings us back to my earlier mention of the decline in ASP and the positive impact on our gross margin.

Overall, ASP declined about 3% sequentially in Q2 but that 3% decline was accompanied by a 6% increase in the revenue we earned on every paid disc shipment in the quarter, which means profit margins are expanding with the decline in ASP, assisted by the seasonal decline in disc shipments and the growth of our lower-priced plans.

Net income of $26 million grew 50% year over year and was 71% above the midpoint of our guidance for Q2. The majority of the outperformance, or about 60%, was due to slower sub-growth and lower marketing expense which accompanied that slower growth, as well as the stronger-than-expected gross margin.

The remainder of the outperformance, or about 40%, was due to our patent infringement litigation settlement with Blockbuster. This was a one-time payment with no ongoing stream of license fees.

The marketing group maintained their spending discipline again this past quarter, spending up to the marginal lifetime value of a subscriber to grow our business, which maximizes our total profit.

To put the impact of our marketing spending in perspective, let’s remember that with flat revenue of approximately $305 million in each of the last two quarters, we more than doubled net income from $10 million to $26 million as we reduced marketing spending sequentially by $27 million, or one-third.

Free cash flow in the quarter of $6.5 million was modestly positive after last quarter’s negative free cash flow of $18 million but would have been nearly break-even without the Blockbuster settlement. The principal contributors to the improvement in cash flow were the $16 million sequential increase in net income, plus a decrease in prepaid expenses, combined with the reduction in both fixed asset and DVD purchases. Like last year, we expected comparatively strong cash flow in the second-half of the year.

Today’s earnings release introduces guidance for Q3 and Q4. Our guidance includes a downward revision in ending subscribers and net income for 2007. This was the second consecutive quarter in which Blockbuster’s willingness to lose money on its Total Access program slowed our sub growth.

Because we think they operate Total Access at a 5% to 10% gross margin, the more subs they get the more money they lose after deducting marketing and fixed expenses. Last quarter, I estimated their online business would lose more than $200 million this year. If they continue to operate their online business this way, we’ll continue to operate in a challenging competitive environment.

As Reed mentioned, we are assuming Blockbuster continues on its current path. That means we expect continued pressure on our ability to grow our sub-base profitably. So while we were pleased with this quarter’s near record net income, we are also feeling pressure to arrest the shift in market share and reaccelerate sub growth.

The increased investment in growth relative to profits that Reed spoke about today is another positive if modest step towards slowing the shift in market share.

On last quarter’s earnings call, Reed told you that we needed to see an acceleration in our subscriber growth as compared with current trends to reach 20 million subs by 2012, and without an acceleration in subscriber growth and profit, we can’t deliver the 50% annual earnings growth we once targeted for the business. In 2008, by way of example, we may see a decline in net income on a year-over-year basis.

Two important assumptions underlie our expectations for 2008. The first is that the current competitive environment remains unchanged and the second assumption is if we significantly increase our investment spending in Internet-delivered video. As Reed indicated, we expect to debut Internet delivery to the TV next year. That will involve increased investment, primarily in content as increasing numbers of Netflix subscribers choose Internet delivery.

Last quarter, we announced a program to buy back $100 million of Netflix stock. To date, we’ve purchased 1.4 million shares at a cost of approximately $30 million. If the business performs as we expect over the next two quarters, we’ll complete the buy-back program by year-end and finish the year with more than $350 million in cash and no debt on our balance sheet.

In summary, Q2 was our first quarter of declining subs and our first quarter with more than $25 million in net income, excluding the realization of the deferred tax asset in Q4 of 2005.

The business model is performing well from a P&L perspective but our growth has slowed in this rapidly growing online rental market. With Blockbuster losing more than $200 million a year to grow its online business, we are unable to grow subscribers as fast as we’d like to and maintain strong profit growth and so we are gradually investing more resources to drive growth at the expense of profit.

That’s the goal of the increased investment in growth Reed spoke about earlier -- to change the growth trajectory of our business by changing the competitive value proposition of our service.

Last quarter I told you we value profit more than growth. We saw that emphasis play itself out in last quarter’s results. But profit growth outpaced sub growth to such an extent last quarter that we think the pendulum swung too far and our guidance for the remainder of 2007 reflects our decision to compete more aggressively for new subscriber growth than we did last quarter.

When Blockbuster decides to operate its online business profitably, our financial results will improve also. But until that time, both sub growth and earnings will remain under pressure.

That concludes my prepared remarks and now we’ll open the phone lines to answer your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come from Barton Crockett with JP Morgan.

Barton Crockett - JP Morgan

Okay, great. Thank you very much for taking the question. I wanted to ask I guess one thing following up on the sort of teaser information, I guess I’ll call it, you gave us about 2008. I take it at this point you’re giving us some qualitative information saying you may see stepped up investment in the Internet video and you’re assuming the competitive environment is unchanged but you are not providing EPS guidance at this point for 2008 specifically. But I was wondering if you could provide us any qualitative sense of whether your baseline view right now is whether ’08 is higher or lower than what you are saying now for ’07. So that would be the first question.

Barry McCarthy

Well I don’t see it being any higher than current year and there’s a possibility that they’ll be lower. Mostly what I see when I look across the sell side research are forecasts for increases on a year-over-year basis. I’m trying to signal that I think that’s overly optimistic, given the level of investment in growth we plan to make in the business.

Barton Crockett - JP Morgan

And then the second thing I was wondering about is if we go through the changes in the guidance, it looks like the reduction to the back-half after kind of backing in the level of -- your guidance in the second quarter and what you’ve printed here. Something in the range of, you know, a reduction of I guess in the $0.20 to $0.33 range. What is the principal driver of that? Is it the price reduction or is it lower subs than you had anticipated? In other words, how much of is it kind of competitive versus just a change in your pricing plan?

Barry McCarthy

Well, there’s some of both, primarily related to pricing.

Barton Crockett - JP Morgan

And then the final thing and then I’ll jump off here; Blockbuster said in their presentation to lenders that they’ve done some survey work that says that 60% of video renters, DVD renters, want a combination of store and online, 20% want store only, 20% want the online subscription only. Since their numbers are out there, I was wondering if you guys have any counterpoint to that, any research you’ve done that either supports or contradicts what Blockbuster is putting out there?

Reed Hastings

The consumers want a value and if you give away a lot of free store rentals, I’m sure they respond positively, as we’ve seen in the numbers. I think really the issue is Blockbuster is willing to lose a lot of money to grow their share and that makes a tougher climate for us, and they could do that by, for example, having online only and cutting the price in half, or they could do that with $200 million of marketing, or they could do it with free store rentals. How they do it is not that relevant. What’s relevant is that they are willing to subsidize the business to a great degree because they feel that it’s a wise course for them. So again, it’s -- I think it’s become clearer that online rental is going to become the dominant form or rental and we’re seeing a share scramble and it looks like they think they were a little behind and so they’ve got to invest a lot to catch up. But presumably they are going to be interested in profits in that business over time also.

Barton Crockett - JP Morgan

Okay. All right. I’ve asked enough questions. Thank you, guys, very much.

Operator

Our next question will come from Douglas Anmuth with Lehman Brothers. Please go ahead.

Douglas Anmuth - Lehman Brothers

Thank you. It seems like you think that you can shift the competitive landscape, at least to some degree, by lowering prices and then next year shifting more into digital, so digital is obviously a big part of the story next year in terms of the spending. But could you talk about what you are seeing so far in terms of churn rates or customer satisfaction with your instant viewing users? Can you also talk about the impact that you’ve seen so far of the BBI mail only product? Thank you.

Barry McCarthy

I’ll take those in reverse order. In terms of the BBI mail only, they don’t promote that. They promote integration with a store and we compete with Total Access. I doubt many people, many consumers know that they have a mail only program, so I don’t think that’s a relevant competitive point for us.

Second, you stated that the dollar price cut will make a difference now and then over time, instant viewing. You know, the dollar price cut is one tactic. The other tactics that we are doing are improving the service levels throughout the business, and those all get traded off against each other as ways to efficiently grow so I wouldn’t put as much emphasis on the price cut as opposed to really again at the strategy level, what we are doing is shifting some profits over to be more competitive and some of that’s going into price cuts, some of that is going into service levels.

In terms of the retention impact in instant viewing, what we certainly believe is the more people use Netflix, whether that’s DVD or instant viewing, the more they perceive they are getting a value and that those are the things that drive retention, and online viewing because of the lack of mailing the disc is inherently a lot more efficient way to deliver movies, so we are pushing into that to harvest those increased efficiencies but it’s still at a relatively small volume, again being on the PC only, so we’ll know more about it next year as we are getting closer to television access.

Operator

Are there any further questions?

Douglas Anmuth - Lehman Brothers

No, you can go ahead.

Operator

Thank you. We’ll move next to Youssef Squali with Jeffries & Company.

Youssef Squali - Jeffries & Company

Thank you very much. Barry, I was wondering if you could qualitatively comment on your ’08 revenue. I think Q3 we’re going to see the first sequential decline in revenues and you are guiding for a similar trend in Q4. How are you looking at ’08 versus ’07?

Barry McCarthy

I don’t have any additional comments to make on ’08. We haven’t begun our planning process yet. I can say I know enough about the business to have concluded that the street forecasts I’ve seen look excessively optimistic. We will talk about ’08 on our fourth quarter call probably, if we follow last year’s pattern and not have more to say about it before then.

Youssef Squali - Jeffries & Company

And then, the trend in your ARPU seems to indicate a pretty aggressive drop. I think in Q2 it was around $15.24 and in Q3 at the midpoint is in the mid $14, and then it drops below $14. Are you baking in another price drop or is it just a mix shift towards lower price plans?

Barry McCarthy

Just a mix shift as we move towards equilibrium, meaning the mix of new customers becomes the same as or nearly the same as the mix of the installed base.

Youssef Squali - Jeffries & Company

Okay and my last question for Reed; Reed, I was wondering, why did you decide to settle the patent with BBI if you believe that your patent was strong enough to prevent them from continuing to expand their business, going to hurt you in the short-term, at least?

Reed Hastings

You know, in any settlement, it’s because the facts as they appear to both sides indicate that a settlement makes sense, so it made sense to us given the facts present at the time, and presumably it made sense to Blockbuster, so that’s why we were able to find mutual ground. Now we are both focused on growing the online rental market as fast as we both can.

Youssef Squali - Jeffries & Company

Thank you.

Operator

We move now to Mike Olsen with Piper Jaffray.

Mike Olsen - Piper Jaffray

I have a couple of questions on the online initiative for download. Basically, it seems like one of the biggest issues for online services is figuring out how to solve this whole last 10 feet problem and that you kind of alluded to it. Can you give us any more flavor as far as how you are looking at this, and what are some of the potential options for you to solve that problem?

Reed Hastings

Well, you are absolutely right that it’s one of the biggest issues holding back the entire industry and we’ll come forth with a variety of solutions next year, but it’s going to be a slow evolution. This Internet to the television isn’t going to happen in one or two years, which is why we think online video grows slowly over the next five and 10 years for movies is because of the adoption cycle to get to the television won’t be overnight. This is a slow adoption like that, steady over five or 10 years. It very much favors an incumbent such as ourselves that can make the investments and hybridize the program that is putting online video and DVD together.

Mike Olsen - Piper Jaffray

Okay, that makes sense. And then, just one question, similar; as far as -- right now, I guess, on the competitive front, the focus is on Blockbuster but in download, Apple is probably going to be one of your bigger competitors. Can you just talk about how you feel your position relative to Apple and what would be your thoughts if Apple has a movie rental service on iTunes at some point?

Reed Hastings

Sure. Today, there’s three segments of online video -- there’s an advertising supported segment that we think will be quite large, that’s led by companies like YouTube and BC.com and a variety of sites, and then there’s DVD purchasing, or rather movie purchasing, which is what Apple’s been focusing on, a $10 to $15 price point. Amazon is in that space and that makes sense as extensions to their businesses. And then there’s the third segment around rental that we’re the clear leader in at this point. And so that’s how I see the segmentation.

To the degree you asked does Apple go with a transactional rental, that basically then becomes a reimplementation of cable video on demand and hard to see how and why it gets traction, because it’s like video on demand except you have to buy an additional box for it but it doesn’t offer anything beyond what you get on cable video on demand.

So that’s not particularly concerning. Remember, the DVD rental has always competed successfully against DVD sales, video on demand, et cetera. So it’s a pretty large market, about $40 billion in the U.S., including the theatrical side, so there’s a lot of room there for a number of approaches.

Mike Olsen - Piper Jaffray

Okay, thanks, and then just one question for Barry -- any thoughts on tax rate for the next few quarters? Are we going to stick at 41% or so?

Barry McCarthy

Yes, cash taxes of course will be less than -- a little less than half of that, but the nominal tax rate will be about 41%.

Mike Olsen - Piper Jaffray

Okay, that’s it for me. Thank you.

Operator

Tony Wible with Citigroup, your line is open. Please go ahead.

Tony Wible - Citigroup

You guys talked about making some smaller changes to your marketing expenditures. What are you thinking about that on a seasonal basis? Would it still make sense to ramp up marketing a little bit more in peak seasonal time periods?

Reed Hastings

Sure, the marketing spending will follow seasonality to a degree. That definitely makes sense.

Tony Wible - Citigroup

And I know it’s still a little early for the high-def format, but what percentage of your discs shipped now are high definition and what does that cost typically run versus the standard definition disc?

Reed Hastings

Unfortunately, high def is still pretty small for us. I don’t know exact numbers, maybe a percent or something. That’s true industry wide. It’s relative to the small adoption. We’d like high-def to be a big success. We’re doing everything we can, that the studios dual-adopt both formats. We think that’s the right solution for the studios to support both formats, get the perception of the war over.

From a cost point of view, postage, handling, all that’s identical. Content cost is a little bit higher right now but that’s because it’s so early adopter, so I don’t think it’s going to be any higher once this becomes a mainstream format.

But right now I’m going to estimate that it runs maybe 10% higher per unit.

Tony Wible - Citigroup

Last question -- have your thoughts on international changed at all in light of the competitive environment in the U.S. heightening and seeing Blockbuster pulling more away from the international environment?

Reed Hastings

Well, I agree that Blockbuster is pulling away from the international environment but it hasn’t changed our perspective on it, and certainly our primary focus is growing the DVD subscriber base and the expansion into online video and those rights for online video are very much country-specific.

Tony Wible - Citigroup

Thank you.

Operator

We go next to Heath Terry with Credit Suisse. Please go ahead, sir.

Heath Terry - Credit Suisse

Thank you. I was just wondering; you mentioned several times Blockbuster losing money on their offering. Based on the intelligence that you have, can you give us an idea of what you feel like they are losing, either on a per customer basis or on a total basis, and how long just again from your perspective you think they are going to be able to keep that up?

Barry McCarthy

They have an earnings call Thursday, Heath, and so that will be a timely opportunity to pose that question to them. They don’t actually disclose that information so we make an educated, informed guess from the models that we keep of their business that gives us insight into the competitive environment, and we’ve said consistently this year that in total we expect the online business to lose north of $200 million, paced by subscriber growth. So if they end the year just south of $5 million, it could be as high as $230 million. If they are tracking closer to $4.5 million, it will be less.

I said in my remarks that I thought that, I estimate that the gross margin on their online business, including the cost of the in-store fulfillment for Total Access and less fulfillment costs, which is how we account for our online business, running in the 5% to 10% range, and I think they ran at a negative gross margin in Q1. They’re making some slight improvements but really there needs to be large structural changes in the value proposition for them to convert that business to a moneymaker.

Reed Hastings

Heath, we have the information to be able to estimate bottoms-up cost, but from an outside point of view, you can just take their store revenue and apply the gross margin that movie gallery generates. It’s been pretty consistent. It’s what store rental runs at and from that, you can back into some top-down numbers.

Heath Terry - Credit Suisse

Thank you very much.

Operator

Our next question comes from Gordon Hodge with Thomas Weisel Partners.

Gordon Hodge - Thomas Weisel Partners

Good afternoon. I just want to dig in a little bit and I may have missed a little bit of your comments, Barry, or didn’t understand it well enough on gross margin, because you handily beat our estimate there again in the quarter. I’m curious about a couple of things. One, I think you mentioned that seasonally, usage was down, which we would expect, but I’m wondering also if you are losing, if you can sense whether you are losing high usage customers to Total Access, if that’s the dynamic that seems to be playing out, and then also just wondering if maybe you could just review, go over it again, just why you are able to absorb the postal increase and generate the margins that you are.

Barry McCarthy

Well, the gross margin was more or less in line with our expectations. We continue to make good progress, as we have for many years, in lowering on a per-disc-shipped basis cost for fulfillment and content related costs, which is driven by effective merchandising on the site, which contributes to the long tail.

We also benefited from some slightly lower credit card fees in the quarter. MasterCard revised our rate and those were the primary contributors, plus the seasonal change in usage which we alluded to.

I don’t have any particular insight, nor do I think there’s a shift that’s occurring with respect to high users, frequent users of DVD. I think to the extent that there’d been a shift in the installed base away from us and towards the Total Access program that that’s already taken place.

Gordon Hodge - Thomas Weisel Partners

Terrific. And then another question, if you don’t mind, just on the marketing spending decision tradeoff versus the decision to cut prices. It sounds like you saw some nice elasticity or some consumer response to the $13.99 price cuts, or the move to $13.99, I should say, and I assume the same was true at $4.99, yet your guidance would suggest you are not expecting a lot of elasticity in reaction to the price cut today. Is the idea here just strategically to put pressure on Blockbuster throughout the year with this price cut, with a view that maybe you get some relief next year and maybe you might attain an ability to raise price later one?

Reed Hastings

It’s certainly not designed to put pressure on Blockbuster. They’ve got plenty of pressure on them. It’s designed to be more attractive to consumers, so the brand and category were very unknown four or five years ago, and so a much heavier investment in marketing was necessary.

If you think from a high level in a big competitive battle where they’re investing heavily in advertising online rental, we are -- we can sort of split the load in terms of the awareness of the category. There’s over 10 million online renters today who are telling their friends about it. There are all these things that says the market, you all need to more compete on value and less on promotion. I think that’s the evolution that you are beginning to see, again as the market is now more than 10 million total subscribers.

So our actions are driven by how to grow our business as we’re going through this competitive storm, because again we and I think our competitor realize that online rental absolutely has the potential to be 20 million in three years and maybe quite a bit bigger beyond that, so we’re doing the big share jockeying right now.

Barry McCarthy

I would also add that with respect to elasticity, it’s helpful to remind yourself that decreasing significantly the marketing spending in order to offset some of the cost of the price decrease, and if we weren’t doing that and could effectively deploy those monies, you would see a different forecast for sub growth than you are seeing.

Gordon Hodge - Thomas Weisel Partners

Yes, okay. That makes sense. Thanks.

Operator

Our next question will come from Maurice McKenzie from Signal Hill. Your line is open.

Maurice McKenzie - Signal Hill

Thank you for taking the question. I just have one -- can you discuss other elements of the competitive environment, such as Red Box and the cable MSOs during the quarter, whether or not those had any impact on overall sub growth?

Reed Hastings

We’ll take them separately. Red Box, DVD Play, and the New Release I think are the three companies that are leading the kiosk business with these $1 a day rentals in supermarkets, primarily. From what we can tell, they are coming from a small base but growing nicely. They are all new release focused and will be an increasing pressure on video stores and they are directly competitive with video stores. Not terribly competitive with ours because we are much more catalog oriented but they are still pretty small, so in the background but have good significant potential over the next three years, mostly to negatively impact stores, which of course has a positive effect for us.

And then you mentioned cable, video on demand -- not much changing in that space. There’s a movie or two that’s coming day-and-date with DVD but across the year, that’s not much of a change. Again, I mentioned that if you sum up Movie Gallery’s, Blockbuster’s and our rental revenue on a domestic basis, that it has actually grown from Q106 to Q107, so despite all those various competitors, consumers are sticking with DVD rental.

Maurice McKenzie - Signal Hill

Reed, just as a follow-up, are there any alliances that are particularly interesting to you, those that may expand your reach or penetration?

Reed Hastings

I’d say our competitive view is that we should focus forward in online video, so if you see us doing various partnerships, we would be probably more inclined to do that. In the area of which -- we’re an Internet company, we look forward on these things, rather than trying to go tit-for-tat with Blockbuster on more their core area being store logistics. Today, stores are probably more relevant to most consumers than online video, partially because it’s only to the laptop. But stores are going to be less relevant every year over the next five years and online video is going to be more relevant every year over the next five years.

We have a great balance sheet. We’re investing in online video. We’re moving forward and that’s the way we look at the world.

Maurice McKenzie - Signal Hill

Reed, thank you very much.

Operator

We go now to Jim Friedland with Cowen and Company.

Jim Friedland - Cowen and Company

Thanks. First on free cash flow, the guidance you said getting to $350 million in cash by year-end implies that you’ll have some decent free cash flow in the second-half, so the first question is based on the new strategy, especially looking into ’08, it sounds like you think you can continue to operate the business by generating free cash flow. The second question is on the expenses relating to the online video business, Watch Now. You said you would get to 5,000 titles by year-end and in Q2, the tech and dev spending went up pretty significantly sequentially. I know you don’t want to give us guidance on stuff like that but as we think about costs going into next year, what’s the primary driver in terms of increased expenses? Is it going to be the goal to get to 10,000 movies by year-end and that’s going to be the primary driver? Or is it something in tech and dev? And then what specifically in tech and dev is driving that ramp? Thanks.

Barry McCarthy

The answer to question one, free cash flow positive in 2008 is yes, we think we can operate the business with positive free cash flow.

The answer to the second question related to tech and dev spending is there were some one-time fees which we incurred this quarter and I expect the absolute level of spending to decline as compared with the second quarter in Q3 and Q4. So the apparent ramp in spending from Q1 and Q2 will now be the ramp going forward.

Jim Friedland - Cowen and Company

And on the availability of titles for Watch Now, again at 5,000 at year-end, as you look out to ’08, is the restriction in getting those titles up to 10,000 a limit that the studios are putting out there because you are getting the titles that are available, or is it more you are just trying to grow it systematically so you don’t kill the P&L?

Reed Hastings

Adding titles doesn’t particularly cost us. It’s the actual viewing, so the more people watch, the more we owe the studios, which is fair and appropriate. So the big drivers would be if we had 500 really great titles, like we’ve had seasons of the Office, the U.S. version of The Office, that have been very popular. So those drive up costs but also increase satisfaction.

So our costs again aren’t related to how much, how successful we are promoting online video and there’s only very small costs, things like encoding, some fixed contract stuff, to the per title count.

Jim Friedland - Cowen and Company

Okay, that’s helpful. Thanks.

Operator

We’ll go now to Barton Crockett with JP Morgan.

Barton Crockett - JP Morgan

Great. I wanted to come back with a follow-up. I was wondering, there’s been some commentary about a level of price Blockbuster might contemplate if they were to charge more for the in-store feature, particularly I think [Antiocho] said at their annual shareholder meeting that hypothetically, there could be a situation where they could raise the rates $2 for that. Our model is assuming a $3 price hike in the fourth quarter, at least at this point. What is your sense of the impact that would have on the Blockbuster, the interest in their Total Access versus Netflix? Do you think that would be, at that level of price, $2 to $3, where people are maybe taking four to five discs out of a store right now but at $2 to $3 price hike for that, would that help you a lot, or not? I was wondering if you could shed some light on that.

Reed Hastings

Every dollar makes a difference. $3 makes more of a difference than $2, $5 makes more of a difference than $4, so it’s pretty continuous. There’s no big inflection points across there and if they choose to do a price increase, that will rebalance the relative share growth to a degree but they may choose not to. I mean, it’s anybody’s guess at this point on how they look at the world.

I think you can see the significance of their commitment in their P&L in the last two quarters because they see that the consumers are voting for online rental and they need to do some catch-up there.

Barton Crockett - JP Morgan

Okay, great. And then also, just on the guidance for the back-half, can you give us a sense -- I mean, the churn was up year to year here in the second quarter. Are you assuming in your guidance that there’s a comparable year-to-year growth in churn in the back-half?

Barry McCarthy

We’re assuming that the same seasonal pattern applies as last year, so by way of example in the current quarter, churn was 4.6%, up 20 basis points sequentially and it was up 20 basis points sequentially a year ago. But this year was about 30 basis points higher than it was last year, so we are feeling the effects of competition, like we said we would, and we did anticipate that the effects of competition would diminish slowly over time and that’s still our view. Now, we’ll have to see how today’s announcement plays itself out in the marketplace in the form of churn.

Barton Crockett - JP Morgan

Okay, great. And then also, the final question here, what did the patent payment that you got from Blockbuster, which line did that fall into on the income statement this quarter?

Barry McCarthy

That was broken out separately in the release. I’m quickly thumbing for the P&L. Bear with me a moment and I’ll point you towards it.

Barton Crockett - JP Morgan

Was that in interest in -- oh, here it is in legal settlement. I see it. Okay.

Barry McCarthy

Yes, and operating expenses, the last line before total operating expenses.

Barton Crockett - JP Morgan

Okay, thank you very much.

Operator

We go now to Daniel Ernst with Hudson Square Research.

Daniel Ernst - Hudson Square Research

Good evening. Thanks for taking the call. Three questions, if I might. First, G&A is up around 74% it looks like year on year. Could you talk about where those resources are being focused and is there a potential here to reverse that trend? And then two questions on the online market. Where are you now, if you sort of looked at the online or the Watch Now subscribers, ex the mail component of those service? Where would the gross margins be falling, given usage and what it’s costing you to deliver both the technology and rev share back to the studio? And then that longer term, where do you see the economics of the digital delivery going? Is it more like rev share and less like DVD acquisition? Can you give me some color on what the economics of an all digital domain might look? Thanks.

Barry McCarthy

Well, in terms of G&A, the trend is up in part related to some legal spending in the quarter. If litigation diminishes going forward, we’ll see some relief there. We have expanded our investment in content group, which is rolled up in the G&A and there’s been some increased investment in systems related to the finance staff. I expect those to be relatively flat on a go-forward basis.

In terms of online Watch Now related stuff, I’ll kick that over to Reed.

Reed Hastings

The costs per movie delivered are less online, as you would imagine. The good part is the studio gets the -- the revenue or the costs instead of splitting between the studio and the post office, so studios are happy with it because it increases their percentage of the pie. Consumers are happy with it because it’s immediate and because it costs less per movie essentially to deliver.

You asked about the pricing structure and the margin structure in that market and I think the market is just too immature to tell. Pricing is often competitively determined. It’s one of the big reason we’re investing in the DVD subscriber base, because we think the magic combination for leadership and profits is combining DVD rental with online video and getting out of the pure commodity space, so the online video players

Daniel Ernst - Hudson Square Research

Thanks.

Operator

Any further questions, Mr. Ernst?

Daniel Ernst - Hudson Square Research

No.

Operator

Okay, we’ll go now to Brian Pitz, Bank of America Securities. Please go ahead, sir.

Brian Pitz - Bank of America

Thanks. Can you give us some details on your marketing spending in the quarter, maybe your offline versus online mix, as well as any color on the mix of online spending by type in terms of keyword, CPM, CPA, and then I’ve got a quick follow-up.

Reed Hastings

For competitive reasons, I’ll defer. We move between all those categories based upon what we perceive is the relative efficiency of those and the deals that we get, so it’s fairly fluid and it’s relatively useful and proprietary knowledge for us.

Brian Pitz - Bank of America

Okay, and then just a quick one on, you mentioned mail cost in the quarter, up about 2%. First-class mail, we know the postage, I think it was on May 14th, increased. Is the 2% because of the timing of the increase mid-quarter? Can you talk about going forward, how we should think about the increased costs of mail on a full quarter basis? Thanks.

Barry McCarthy

On a per-disc-shipped basis, it’s about $0.04, $0.02 each way. We don’t actually break out the cost of postage and packaging. I don’t have any comments except to say we’ll pick up a full quarter’s worth in Q3 and we picked up a partial quarter in Q2.

Brian Pitz - Bank of America

Great, thank you.

Operator

That concludes today’s question-and-answer session. At this time, I’d like to turn the program back to Mr. Hastings for any closing remarks.

Reed Hastings

Thanks, Operator. So everyone, our revised guidance of course is based on the assumption that Blockbuster doesn’t change course at all over the foreseeable future. We don’t know if that is too conservative or not but we thought it the most prudent assumption. What we can certainly see is that consumers are not turning away from DVD rental but they are definitely switching from store-based rental to online rental and that’s apparent to all of the players in the market. So it could be a fairly intense competitive battle here as people play for that big market over the next couple of years.

So with that, I would like to thank you for participating I look forward to talking to you again in the quarter.

Operator

Thank you, everyone, for your participation in today’s conference call. You may disconnect at this time.

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